4.1 Total Benefits |
The benefits are those elements that add to the welfare of the organization. Most elements contain both costs and benefits. As such, they may appear on both costs and benefits sides of the calculations. As a rule, only realizable benefits should be included. These are benefits that will be realized to the organization. In some cases, such as for service groups, potential benefits are also included. These include benefits that could be realized if the service was offered on a commercial basis. Great care should be taken in using potential, non-realizable benefits since their inclusion with the realizable benefit could reduce the creditability of the analysis. |
4.1.1 Cost Reduction |
The most apparent benefit is often cost reduction for given work done.
However, this cost reduction often results with an increased use of the resource.
Economists have long argued that a relative increase is the productivity of a resources
(or reduction in cost per unit produced) should result in a relative increase in the use
of that resource. For example if the cost to produce a report decreases due to office
automation, one would expect that the number of reports produced should increase against
other forms of communications. As such the value of office automation would include not
only be the decrease in cost for the existing number of reports but the value of the new
reports. If there is not an increase in use, the saving may need to come from reduced staff. If the staff is fixed, however, this benefit may not be realized. Until recently, it was normally assumed that the demand for output would continuously increase and therefore, the benefits would be realized. |
4.1.2 Cost of Quality |
Quality of the product may improve with automation. The value of this improvement comes from (1) the cost of poor quality, and (2) the value of quality improvement. The cost of quality can be easily assigned if poor output needs to be reworked. Under this condition, the expense of reworking is the cost of poor quality. This could also be seen in additional research time needed to make a decision. That time could be assign to the cost of quality. |
4.1.3 Quality Improvement |
Quality improvement is more difficult to measure, but is often the prime value of automation process. |
4.1.3.1 Free Market Value |
If the improvement in output can be priced for equivalent results against commercial sources then that price premium can be used as a measurement of the benefit for automation. |
4.1.3.2 Impact on Business |
The quality improvement may command a price premium or allow for the capturing of larger market share. Both have economic value to the organization. However, if that share can not be realized, such as a capacity limitation or restrictions on use, and furthermore if competitive pricing is not allowed, then the benefit will not be realized. |
4.2 Life-Cycle Costing |
The costing should be based on the total life of the system. This includes the acquisition of the system, customization, training, implementation, and maintenance. |
4.2.1 Equipment and Materials |
All elements of equipment and software should be included. This
includes supplies, backup equipment, repairs as well as initial purchases. Since some of
these expenses will be realized over time, they need to be accounted in a time series. In general, only items specifically allocated for this function are to be considered. If joint functions are being considered, such as word processing and an accounting system, a partial cost may be used. However, such allocations should be noted in the cost/benefit report. |
4.2.2 Custom Software |
Most systems require some degree of customization of software or the construction of custom programs. The cost of this activity must be included in the total cost. Some additional development may be called for later in the life- cycle of the system. That expected activity is usually considered a separate project and, therefore, not included in the initial systems costs. However, if it is excluded, any potential benefits from that work should also be excluded. |
4.2.3 Training |
Training costs include lost time of personnel as well as any out-of-pocket expenses. This lost time expense should be liberal enough to cover initial decrease of productivity during the transition. |
4.2.4 Personnel |
Personnel replacement and out-services may or may not be included depending on the costing conventions used by the firm. |
4.2.5 Cost of Transition |
Costs associated with the transition between systems should be included as a cost for the new system. Usually conservative practices require that the old and the new systems to be running concurrently for a period of time. This requires increased staff, often using temporary services, costs of data transfer and compilation, and dual paper work. The increased load on operating management, however, is usually not included as a direct cost unless overtime is paid. |
4.2.6 Opportunity Costs |
The commitment to a system usually excludes the exploration of other approaches. This may introduce costs to the organization. |
4.3 Financial Measures |
The result of the cost/benefit is a table of cost and benefit numbers
over time. Several techniques are used to combine these numbers into figures of merit.
[For more information see any of the standard financial management texts such as: Currant, W. S., Principles of Financial Management, McGraw-Hill (1970)} |
4.3.1 Return on Investment |
The return on investment is usually calculated based on the first year's costs as the investment, unless a capitalized investment is used. The return is calculated as a "discounted" cash flow (benefits - costs) over a time period. |
4.3.1.1 Project Life |
System or project life is the reasonable expectation for the working period for the system. Historically, the project or system life has extended beyond the expected life of equipment. Equipment life is generally set between 3 to 5 years depending on capitalization and tax policies. The system life can extend over several decades in the case of mainframe system or at least equipment life for Personal Computer based systems. In general, the time period should range between 3 and 12 years, with 6 being a median value. |
4.3.1.2 Discounted Cash |
Money has a temporal value. The manner in which future cash is valued
is tracked by the discount rate. The Discounted Cash Flow is the equivalent series of
present cash flows. This Discount Cash Flow is also referred to as the Constant Dollar
Cash Flow. All such cash flows refer to a specific date for discounting. That date should
be included with any report including discounting. Usually, a single discount rate is used. Most firms have determined an operational discount rate to be used for project analysis. That discount rate should be used for all analyses unless otherwise noted. |
4.3.2 Net Present Value |
The Net Present Value is the sum of the discounted cash flow. It represents the total value of the system. Note that the net present value is a function of the discount rate, the life span of the system, and if applicable, the number of applications. Computations for Net Present Value are usually available on most spreadsheet packages. |
4.3.2.1 Breakeven Point |
The Breakeven Point is the point where the net present value is zero. The Breakeven Point for a system refers to either the minimum functional life span or the minimum number of applications for the system that would make it worth developing. A greater number of applications or more years of service make the system worth developing. Note that the value to the organization is obtained beyond the breakeven point. The breakeven point is, therefore, the absolute minimum condition for project development. |
4.3.2.2 Internal Rate of Return |
As previously noted, the Net Present Value depends on the discount rate. The Internal Rate of Return is the discount rate for which Net Present Value is zero. Generally for software development programs, there is usually only one Internal Rate of Return. However, if the development program is complex there may be several. Under these conditions, the lowest value is used. Computations for Internal Rate of Return are usually available on most spreadsheet packages. |
4.3.3 Uncertainty |
There is usually significant uncertainty regarding the value and realizability of benefits. It is often useful therefore to test the sensitivity of the analysis and to include risk. |
4.3.3.1 Subjective Probabilities |
Probabilities are often assigned to cost and benefit estimates. These
are then used to obtain a range of values. These probabilities are subjective. They
represent the opinions of assessors to events that have not taken place and for which
there is generally no quantitative historical experience. The probability values are
better viewed as measures of confidence rather than as likely occurrences. However, we
still tend to manipulate them as if they were true probabilities. Care should be taken in
interpreting these results. [For applications and use see Brown, R. V, A. S. Andrew, C. Peterson, Decision Analysis for the Manager, Holt (1974) and Davis, G. B., M. H. Olson, Management Information Systems, Conceptual Foundations, Structure, and Development, McGraw-Hill (1985)] [For theoretical foundations see Fishburn, P. C., Decision and Value Theory, ORSA, No. 10, Wiley (1964)] |
4.3.3.2 Distributed Returns |
Probability estimates of the costs and benefits elements can be
combined using simulation to give a population of cost/benefit figures (Monte Carlo
Simulation). Any of the figures of merit can be used as well as the discounted cash flow. [Anderson, D. R., D. J. Sweeney, T. A. Williams, An Introduction to Management Science, 5th Edition (1987), pg. 504] |
4.3.3.2.1 Average and Median Returns |
The average and median figures of merit are often calculated as representing the effect of risk. The average value, however, can be influenced by a small probability of high return. It is, therefore, less reliable than the median value which is often below the average value. Median value is the calculated 50% point on the distribution. If the calculations are valid, then half the time, results will be better than the median and half the time they will be worse. |
4.3.3.2.2 Envelope of Returns |
Some range of values is usually necessary for uncertain projects. This usually expressed as an envelope of returns. Included is usually an upper figure at 75% or 90% level, a corresponding lower level at 25% or 10% and the median (50%). |